Consumer Law

Moral hazard and adverse selection redux

By Alan White

By Alan White

The Administration's foreclosure rescue plan, expected to be announced next week, will have to contend with the bad incentives it will create for mortgage lenders and servicers.  While much ink has been spilled about moral hazard for borrowers, the delay and uncertainty about foreclosure aid has mostly created moral hazard for servicers.  One of the reasons mortgages are not being restructured with principal reductions now is that servicers are waiting for the government bailout.  Why write down a mortgage to make it work, after all, if Uncle Sam will just write you a check to achieve the same goal?  Thus does the promise of subsidy create a hazard that servicers will continue offering unrealistic modifications that increase principal debt, or delay offering any modifications at all.  While there is welcome news this week that some banks are delaying foreclosures in anticipation of the program, the anticipation is also disincentivizing banks from doing the modifications that need to be done.

The second danger is that of adverse selection.  If Treasury will now be guaranteeing losses on modified loans, or subsidizing interest payments, rational servicers will choose the loans with the largest potential losses to nominate for the government program.  Any subsidy going to mortgage lenders and investors has to be very carefully designed to reward only successful and sustainable mortgage modifications.  At a minimum we need foreclosure reduction goals, monthly reports on progress towards the goals, and payments to banks and servicers tied directly to performance in reducing foreclosures and mortgage defaults.

Full post as published by CL&P Blog on February 14, 2009 (boomark / email).